Proxy Access Invalidated on APA Grounds

Dodd-Frank § 971 affirms that the SEC has authority to adopt a proxy access rule. At the same time, however, the legislative history makes clear that Congress intends that the SEC “should have wide latitude in setting the terms of such proxy access.” In particular, § 971 expressly authorizes the SEC to exempt “an issuer or class of issuers” from any proxy access rule and specifically requires the SEC to “take into account, among other considerations, whether” proxy access “ disproportionately burdens small issuers.”

Section 971 probably was unnecessary. An SEC rulemaking proceeding on proxy access was well advanced long before Dodd-Frank was adopted, so a shove from Congress was superfluous. Although the SEC lacks authority to regulate the substance of shareholder voting rights, moreover, proxy access almost certainly fell within the disclosure and process sphere over which the SEC has unquestioned authority. By adopting § 971, however, Congress did preempt an expected challenge to any forthcoming SEC regulation.

On August 25, 2010, just a few weeks after Dodd-Frank became law, the SEC adopted Rule 14a-11, which will require companies to include in their proxy materials, alongside the nominees of the incumbent board, the nominees of shareholders who own at least 3 percent of the company’s shares and have done so continuously for at least the prior three years. A shareholder may not use the rule to take over the company. Instead, the shareholder is limited to putting forward a short slate consisting of at least one nominee or up to 25% of the company’s board of directors, whichever is greater. Application of the rule to small companies will be deferred for three years, while the SEC studies its impact on them.

Proxy access has been highly controversial. As SEC Commissioner Troy Paredes pointed out in dissenting from adoption of new Rule 14a-11, proxy access marks a considerable displacement of state corporate law by federal securities regulation:

Rule 14a-11’s immutability conflicts with state law. Rule 14a-11 is not limited to facilitating the ability of shareholders to exercise their state law rights, but instead confers upon shareholders a new substantive federal right that in many respects runs counter to what state corporate law otherwise provides.

Commissioner Paredes further pointed out that:

The mixed empirical results do not support the Commission’s decision to impose a one-size-fits-all minimum right of access. Some studies have shown that certain means of enhancing corporate accountability, such as de-staggering boards, may increase firm value, but these studies do not test the impact of proxy access specifically. Accordingly, what the Commission properly can infer from these data is limited and, in any event, other studies show competing results. Recent economic work examining proxy access specifically is of particular interest in that the findings suggest that the costs of proxy access may outweigh the potential benefits, although the results are not uniform. The net effect of proxy access — be it for better or for worse — would seem to vary based on a company’s particular characteristics and circumstances.

To my mind, the adopting release’s treatment of the economic studies is not evenhanded. The release goes to some length in questioning studies that call the benefits of proxy access into doubt — critiquing the authors’ methodologies, noting that the studies’ results are open to interpretation, and cautioning against drawing “sharp inferences” from the data. By way of contrast, the release too readily embraces and extrapolates from the studies it characterizes as supporting the rulemaking, as if these studies were on point and above critique when in fact they are not.

SEC Commissioner Kathleen Casey pointed out in her dissent that the new rule favors activist investors who may seek to use the new access rights to engage in private rent seeking:

The paradigm of a power struggle between directors and shareholders is one that activist, largely institutional, investors assiduously promote, and this rule illustrates a troubling trend in our recent and ongoing rulemaking in favor of empowering these shareholders through, among other things, increasingly federalized corporate governance requirements. Yet, these shareholders do not necessarily represent the interests of all shareholders, and the Commission betrays its mission when it treats these investors as a proxy for all shareholders.

In this new case, however, the DC Circuit sided with the BRT and Chamber on administrative procedure grounds. candidly, while I am pleased, I'm also surprised. I had thought--and said publicly--that this suit was a long shot. In any event, the court--per an opinion by Douglas Ginsburg--held that:

We ... hold the Commission acted arbitrarily and capriciously for having failed once again — as it did most recently in American Equity Investment Life Insurance Company v. SEC, 613 F.3d 166, 167-68 (D.C. Cir. 2010), and before that in Chamber of Commerce, 412 F.3d at 136 — adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.

That's a pretty serious smack down. "Once again failed," citing cases. "Opportunistically" assessed the evidence. "Contradicted itself." Ouch. The SEC definitely got a serious spanking from a court that was not amused.

Some interesting points. First, the court agreed with those of us who have argued that a board often will have not just the right--but the duty--to oppose shareholder nominees:

[T]he American Bar Association Committee on Federal Regulation of Securities commented: "If the [shareholder] nominee is determined [by the board] not to be as appropriate a candidate as those to be nominated by the board's independent nominating committee ..., then the board will be compelled by its fiduciary duty to make an appropriate effort to oppose the nominee, as boards now do in traditional proxy contests."

Second, the court slapped down the SEC's claim--which parroted the claims of shareholder power advocates--that shareholder activism is beneficial for corporate performance:

The petitioners also maintain, and we agree, the Commission relied upon insufficient empirical data when it concluded that Rule 14a-11 will improve board performance and increase shareholder value by facilitating the election of dissident shareholder nominees. ... The Commission acknowledged the numerous studies submitted by commenters that reached the opposite result. ... One commenter, for example, submitted an empirical study showing that "when dissident directors win board seats, those firms underperform peers by 19 to 40% over the two years following the proxy contest." Elaine Buckberg, NERA Econ. Consulting, & Jonathan Macey, Yale Law School, Report on Effects of Proposed SEC Rule 14a-11 on Efficiency, Competitiveness and Capital Formation 9 (2009), available at www.nera.com/upload/Buckberg_Macey_Report_FINAL.pdf. The Commission completely discounted those studies "because of questions raised by subsequent studies, limitations acknowledged by the studies' authors, or [its] own concerns about the studies' methodology or scope."

The Commission instead relied exclusively and heavily upon two relatively unpersuasive studies, one concerning the effect of "hybrid boards" (which include some dissident directors) and the other concerning the effect of proxy contests in general, upon shareholder value. Id. at 56,762 & n.921 (citing Chris Cernich et al., IRRC Inst. for Corporate Responsibility, Effectiveness of Hybrid Boards (May 2009), available at www.irrcinstitute.org/pdf/IRRC_05_09_EffectiveHybridBoar ds.pdf, and J. Harold Mulherin & Annette B. Poulsen, Proxy Contests & Corporate Change: Implications for Shareholder Wealth, 47 J. Fin. Econ. 279 (1998)). Indeed, the Commission "recognize[d] the limitations of the Cernich (2009) study," and noted "its long-term findings on shareholder value creation are difficult to interpret." Id. at 56,760/3 n.911. In view of the admittedly (and at best) "mixed" empirical evidence, id. at 56,761/1, we think the Commission has not sufficiently supported its conclusion that increasing the potential for election of directors nominated by shareholders will result in improved board and company performance and shareholder value....

I have consistently argued that proxy access will not result in improved board performance, so I'm especially pleased by this aspect of the holding. See, e.g., Shareholder Activism in the Obama Era (July 22, 2009).

Third, the Court agreed with those of us who have argued that certain institutional investors--most notably union pension funds and state and local government pension funds--would use proxy access as leverage to extract private gains at the expense of other shareholders (see my Obama Era article, cited above):

Notwithstanding the ownership and holding requirements, there is good reason to believe institutional investors with special interests will be able to use the rule and, as more than one commenter noted, "public and union pension funds" are the institutional investors "most likely to make use of proxy access." ... Nonetheless, the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause companies to incur costs even when their nominee is unlikely to be elected.

Note how Paredes and Casey are also vindicated here.

This is a big win for those of us who believe in the board-centric model of corporate governance and for the dominance of state law in regulating corporate governance.

But it is not the end of the story. Obviously, the SEC could appeal. The SEC could also go back to the rule-making process and try again. Neither would be surprising. Proxy access is a major goal of the union bosses and therefore has strong support from Democrats in Congress and the Democratic members of the Commission.

In addition, there is a private ordering solution. Shareholders who want proxy access can put forward proposals under Rule 14a-8 to amend the issuer's bylaws so as to permit shareholder nominees to be included on the proxy card.

Dodd-Frank § 971 affirms that the SEC has authority to adopt a proxy access rule. At the same time, however, the legislative history makes clear that Congress intends that the SEC “should have wide latitude in setting the terms of such proxy access.” In particular, § 971 expressly authorizes the SEC to exempt “an issuer or class of issuers” from any proxy access rule and specifically requires the SEC to “take into account, among other considerations, whether” proxy access “ disproportionately burdens small issuers.”

Section 971 probably was unnecessary. An SEC rulemaking proceeding on proxy access was well advanced long before Dodd-Frank was adopted, so a shove from Congress was superfluous. Although the SEC lacks authority to regulate the substance of shareholder voting rights, moreover, proxy access almost certainly fell within the disclosure and process sphere over which the SEC has unquestioned authority. By adopting § 971, however, Congress did preempt an expected challenge to any forthcoming SEC regulation.

On August 25, 2010, just a few weeks after Dodd-Frank became law, the SEC adopted Rule 14a-11, which will require companies to include in their proxy materials, alongside the nominees of the incumbent board, the nominees of shareholders who own at least 3 percent of the company’s shares and have done so continuously for at least the prior three years. A shareholder may not use the rule to take over the company. Instead, the shareholder is limited to putting forward a short slate consisting of at least one nominee or up to 25% of the company’s board of directors, whichever is greater. Application of the rule to small companies will be deferred for three years, while the SEC studies its impact on them.

Proxy access has been highly controversial. As SEC Commissioner Troy Paredes pointed out in dissenting from adoption of new Rule 14a-11, proxy access marks a considerable displacement of state corporate law by federal securities regulation:

Rule 14a-11’s immutability conflicts with state law. Rule 14a-11 is not limited to facilitating the ability of shareholders to exercise their state law rights, but instead confers upon shareholders a new substantive federal right that in many respects runs counter to what state corporate law otherwise provides.

Commissioner Paredes further pointed out that:

The mixed empirical results do not support the Commission’s decision to impose a one-size-fits-all minimum right of access. Some studies have shown that certain means of enhancing corporate accountability, such as de-staggering boards, may increase firm value, but these studies do not test the impact of proxy access specifically. Accordingly, what the Commission properly can infer from these data is limited and, in any event, other studies show competing results. Recent economic work examining proxy access specifically is of particular interest in that the findings suggest that the costs of proxy access may outweigh the potential benefits, although the results are not uniform. The net effect of proxy access — be it for better or for worse — would seem to vary based on a company’s particular characteristics and circumstances.

To my mind, the adopting release’s treatment of the economic studies is not evenhanded. The release goes to some length in questioning studies that call the benefits of proxy access into doubt — critiquing the authors’ methodologies, noting that the studies’ results are open to interpretation, and cautioning against drawing “sharp inferences” from the data. By way of contrast, the release too readily embraces and extrapolates from the studies it characterizes as supporting the rulemaking, as if these studies were on point and above critique when in fact they are not.

SEC Commissioner Kathleen Casey pointed out in her dissent that the new rule favors activist investors who may seek to use the new access rights to engage in private rent seeking:

The paradigm of a power struggle between directors and shareholders is one that activist, largely institutional, investors assiduously promote, and this rule illustrates a troubling trend in our recent and ongoing rulemaking in favor of empowering these shareholders through, among other things, increasingly federalized corporate governance requirements. Yet, these shareholders do not necessarily represent the interests of all shareholders, and the Commission betrays its mission when it treats these investors as a proxy for all shareholders.

In this new case, however, the DC Circuit sided with the BRT and Chamber on administrative procedure grounds. candidly, while I am pleased, I'm also surprised. I had thought--and said publicly--that this suit was a long shot. In any event, the court--per an opinion by Douglas Ginsburg--held that:

We ... hold the Commission acted arbitrarily and capriciously for having failed once again — as it did most recently in American Equity Investment Life Insurance Company v. SEC, 613 F.3d 166, 167-68 (D.C. Cir. 2010), and before that in Chamber of Commerce, 412 F.3d at 136 — adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.

That's a pretty serious smack down. "Once again failed," citing cases. "Opportunistically" assessed the evidence. "Contradicted itself." Ouch. The SEC definitely got a serious spanking from a court that was not amused.

Some interesting points. First, the court agreed with those of us who have argued that a board often will have not just the right--but the duty--to oppose shareholder nominees:

[T]he American Bar Association Committee on Federal Regulation of Securities commented: "If the [shareholder] nominee is determined [by the board] not to be as appropriate a candidate as those to be nominated by the board's independent nominating committee ..., then the board will be compelled by its fiduciary duty to make an appropriate effort to oppose the nominee, as boards now do in traditional proxy contests."

Second, the court slapped down the SEC's claim--which parroted the claims of shareholder power advocates--that shareholder activism is beneficial for corporate performance:

The petitioners also maintain, and we agree, the Commission relied upon insufficient empirical data when it concluded that Rule 14a-11 will improve board performance and increase shareholder value by facilitating the election of dissident shareholder nominees. ... The Commission acknowledged the numerous studies submitted by commenters that reached the opposite result. ... One commenter, for example, submitted an empirical study showing that "when dissident directors win board seats, those firms underperform peers by 19 to 40% over the two years following the proxy contest." Elaine Buckberg, NERA Econ. Consulting, & Jonathan Macey, Yale Law School, Report on Effects of Proposed SEC Rule 14a-11 on Efficiency, Competitiveness and Capital Formation 9 (2009), available at www.nera.com/upload/Buckberg_Macey_Report_FINAL.pdf. The Commission completely discounted those studies "because of questions raised by subsequent studies, limitations acknowledged by the studies' authors, or [its] own concerns about the studies' methodology or scope."

The Commission instead relied exclusively and heavily upon two relatively unpersuasive studies, one concerning the effect of "hybrid boards" (which include some dissident directors) and the other concerning the effect of proxy contests in general, upon shareholder value. Id. at 56,762 & n.921 (citing Chris Cernich et al., IRRC Inst. for Corporate Responsibility, Effectiveness of Hybrid Boards (May 2009), available at www.irrcinstitute.org/pdf/IRRC_05_09_EffectiveHybridBoar ds.pdf, and J. Harold Mulherin & Annette B. Poulsen, Proxy Contests & Corporate Change: Implications for Shareholder Wealth, 47 J. Fin. Econ. 279 (1998)). Indeed, the Commission "recognize[d] the limitations of the Cernich (2009) study," and noted "its long-term findings on shareholder value creation are difficult to interpret." Id. at 56,760/3 n.911. In view of the admittedly (and at best) "mixed" empirical evidence, id. at 56,761/1, we think the Commission has not sufficiently supported its conclusion that increasing the potential for election of directors nominated by shareholders will result in improved board and company performance and shareholder value....

I have consistently argued that proxy access will not result in improved board performance, so I'm especially pleased by this aspect of the holding. See, e.g., Shareholder Activism in the Obama Era (July 22, 2009).

Third, the Court agreed with those of us who have argued that certain institutional investors--most notably union pension funds and state and local government pension funds--would use proxy access as leverage to extract private gains at the expense of other shareholders (see my Obama Era article, cited above):

Notwithstanding the ownership and holding requirements, there is good reason to believe institutional investors with special interests will be able to use the rule and, as more than one commenter noted, "public and union pension funds" are the institutional investors "most likely to make use of proxy access." ... Nonetheless, the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause companies to incur costs even when their nominee is unlikely to be elected.

Note how Paredes and Casey are also vindicated here.

This is a big win for those of us who believe in the board-centric model of corporate governance and for the dominance of state law in regulating corporate governance.

But it is not the end of the story. Obviously, the SEC could appeal. The SEC could also go back to the rule-making process and try again. Neither would be surprising. Proxy access is a major goal of the union bosses and therefore has strong support from Democrats in Congress and the Democratic members of the Commission.

In addition, there is a private ordering solution. Shareholders who want proxy access can put forward proposals under Rule 14a-8 to amend the issuer's bylaws so as to permit shareholder nominees to be included on the proxy card.